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It’s been a rough time for me in the market recently. With the SPY and QQQ roaring, there has been a relative weakness in the small-cap RUSSELL 2000 ETF (IWM). While large caps have been charging ahead, many of the stocks I was in which set up great haven’t followed. I made a plan, and now I have to trade the plan by cutting many of these stocks.

 

Traders will go through challenging periods of underperformance. It happens and is a part of the game. How we react to these situations separates the best traders from people who are forced out of the game. Today we will discuss why it’s crucial to cut trades that are not working.

 

Hope Is Not A Trading Strategy

There are numerous reasons why trades that are not working need to be cut. First of all, hope is not a trading strategy. Legendary trader Paul Tudor Jones once said you never want to wish or hope. You always want to be trading, in control. Cutting trades is all about opportunity costs.

 

Intellectual Capital

Stocks need to be cut when they aren’t working to protect Intellectual Capital. You need to maintain flexibility of thought when trading. There are many trading opportunities that set up throughout the days. You don’t want to be caught up thinking about trades that aren’t working and lose focus on other opportunities that may be setting up across the market.

Getting out of trades frees up your mind to pursue new trading setups.

Psychological Capital

Trading is a performance sport. In order to be able to execute well, you need to be in the best possible frame of mind. Holding on to trades that aren’t working can bring up a host of other issues with your trading. Some of those include revenge trading, fear of missing out (FOMO), incorrect sizing.

If you don’t cut your losses you might see these issues creep into your trading decisions subconsciously not even being aware of them at the time.

 

Emotional Capital

Cutting trades gives you energy to pursue new trading setups. In my experience holding onto bad trades saps your energy. You begin to worry about the trade, sometimes to the point of being sick to your stomach.

Legendary trader Jesse Livermore once said “A loss never bothers me after I take it. I forget it overnight. But being wrong- not taking the loss- that is what does damage to the pocketbook and to the soul.”

Trades need to be cut to protect your emotional capital. Moving on to the next trade as quickly as possible helps maintain your emotional well-being. A vital part of not only trading but your life.

 

Bottom Line

Trades that aren’t working need to be cut as per your plan. Respecting stops is what separates great traders from gamblers. In trading, you always want to be in control, seeking the following great trading setup. Trades need to be cut to protect your psychological, emotional, and intellectual capital, so you are always ready to use your trading skills to the best of your ability.

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

Baron Rothschild once said “Buy when there is blood in the streets, even if the blood is your own”. As traders, we want to be as flexible as possible to take advantage of other people’s misfortune. Trading is a ruthless game and not for the faint of heart, especially when markets are volatile.


Today we will look at the capitulation trade. It’s a classic setup with great risk/reward for those that can stay patient, wait and “see” the trade.

 

Taking advantage of Panic

The capitulation trade is all about taking advantage of the panic. Now there can be panic selling, and there can also be panic buying. Panic buying is known as a blow-off top, which is when price accelerates at an unsustainable rate.

Usually, some trapped short-sellers and FOMO (fear of missing out) will chase the stock at excessive levels before they are met with large selling indicating the top of the move.

To spot this type of move, you want to see an acceleration in price met with a massive block of volume, larger than any previous candle. This trade is all about watching volume rather than chart setups.

For example, let’s look at an American Airlines Group (AAL) setup from last year.

There is some discretion with this type of trade, and because this is a counter-trend trade, risk management is critical. We must respect our stops.

But as we can see on the open the next day, there was a gap up and a fast 35% gain on massive volume move before a rejection candle gave us the confirmation that we need to participate in a trade like this.

The first-hour candle was rejected, the second-hour candle was rejected again on huge relative volume, and then the volume died off. That is the textbook sign of volume that we look for.

There is a considerable increase in volume for someone to get blown out and the smart money to get out (known as a distribution) before they walk and the move is over. The stock then faded 30-50% over the coming days/weeks. This trade is applicable at all time frames.

 

The Hand of God

Now let’s look at a capitulation bottom move in the Russell 2000 ETF (IWM) from a few weeks ago.

We can see the two-volume bars on the 17th and 18th were approximate twice the volume of the previous 10 days. This is the capitulation that we are looking for. This setup is also known as the “Hand of God.”

While some participants are panicking and hitting out of their positions or locking in profits, the “smart money” on the sidelines steps in and hoovers up stock at bargain prices. They will buy as much as they can and then usually demand that prices move higher.

Price may continue higher as participants realize that the panic is over and feel it is safe to get back into the market. There are two more examples of this setup in IWM since March highlighted.

 

Bottom Line

Trading is a ruthless game, and as flexible traders, we want to take advantage of opportunities and other people’s emotions. Psychologically, we can see this play out in large moves in one direction or the other. The capitulation trade is based on the increased volume in unsustainable moves or at attractive levels where smart money steps in. This is one of my favorite trading setups.

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

Corporate earnings and interest rates drive stock prices. With interest rates near 0, we have seen the market charge higher and higher on expanding the Federal Reserve’s (FED) balance sheet.

Despite fears of inflation and discussions of rising interest rates, the market has shaken off all worries to continue higher. There is as of yet no sign of any change in this trend.

 

Balance Sheet Expansion

FED asset purchases, the only chart that matters?

The FED’s balance sheet had expanded from $2 trillion in 2009 post the Global Financial Crisis to $4 trillion in 2020 before the covid-19 virus hit. Emergency intervention in the financial market during the pandemic of 2020 and continued asset purchases in 2021 has seen that figure rise to $8 trillion.

While some market participants fought the market by shorting on economic worries, the demand for financial assets outweighed supply driven by the FED policy.

This asset purchase program has seen markets march higher and higher, and as long as Fed purchases continue, I wonder if it is even possible for the market goes down in a sustained fashion? So far, the answer has been no.

 

Inflation and Interest rates

We have seen pullbacks in the market recently amid inflation fears. CPI readings have overshot expectations at times, and the market has reacted to the Federal Reserve beginning to talk about tapering the stimulus.

However, as Fed balance sheet assets continue to increase, the market shakes off fears of sustained inflation and makes new highs.

From October to November, a 20% drop in 20-year bond prices signaled higher future long-term interest rates, perhaps being the reason for minor market corrections as the market began pricing in inflation and higher rates. However, as shown above, FED asset purchases were increasing, continuing to fuel a rally higher in stocks.

Since March overall, the 20-year bond chart above shows the market is pricing in lower longer-term interest rates than it had been previously. Thus despite FED signaling the beginning of discussions for tapering, the market is pricing in still lower longer term interest rates.

A similar situation occurred during Alan Greenspan’s term in 2005. Despite interest rate increases in the Federal Funds Rate, the 10-year interest rate refused to move, known as ”Greenspan’s conundrum”. That bull market lasted three more years until the Financial Crisis in 2008.

Thus, it appears that the only thing that can hold this bull market back is a reduction in the FED’s balance sheet or out-of-control inflation, which could be a real possibility but at the moment appears transitory.

 

Money Supply

The amount of cash has also risen significantly since the beginning of the pandemic. As shown by the M2 money supply.

Given that there are record amounts of cash with nowhere to go, there is still pent-up demand to find a return on this money given low-interest rates. Perhaps this is why we see a flood of SPACs, cashed-up vehicles looking to take private companies public.

We also see significant investments in speculative cryptocurrencies and NFT’s. Recently an Unopened Super Mario 64 Game From 1996 Sells for $1.56M (cheddar.com). I don’t want to say we’re in a bubble…but we’re in a Fed-induced bubble.

With the stock market at all-time highs, fundamentally, nothing has changed yet. There is still so much money in the system looking for a place to go. Without severe inflation and unexpected rate increases, there is no telling how long this can continue.

Bottom Line

The FED balance sheet has continued to expand post-Covid-19. Even as Inflation indicators spike and interest rate increases are on the cards, the balance sheet expansion may be the leading cause of this vital market. With record cash on the sidelines with nowhere to go but equities due to low-interest rates, there is no reason for this trend not to continue.

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.